AirAsia Philippines and Zest Air outlook improves following tie-up, but challenges remain

See related article: Cebu Pacific sees bright outlook for 2013 as rationality returns to Philippines market

AirAsia Philippines and Zest have an 11% share of the Philippine domestic market

AirAsia Philippines and Zest combined accounted for only 10.8% of the Philippine domestic market in 2012, according to Philippine CAB data. The two carriers also accounted for 2.6% of the international passenger market in 2012, including a 5.7% share of international passengers carried by Philippine carriers (see background information below).

Zest carried 2.4 million passengers in 2012, including 2.1 domestic passengers. AirAsia Philippines carried just under 270,000 passengers in its first year, including almost 160,000 domestic passengers. AirAsia Philippines, which is 40% owned by the Malaysia-based AirAsia Group, launched services in late Mar-2012.

The duo currently operates a fleet of 13 A320s, including 11 A320s at Zest and two at AirAsia Philippines. Zest also has a fleet of turboprops which are expected to be rapidly phased out as AirAsia and Zest look to jointly expand their A320 fleet, leveraging the huge order book from the AirAsia Group. Phasing out the turboprops will also free up slots at Manila for more Zest/AirAsia flights on domestic trunk and regional international routes.

AirAsia tie-up gives new life to Zest

Zest has struggled in recent years and was seen as the most vulnerable of the five LCCs serving the Philippine domestic market in 2012. But Zest has a valuable portfolio of slots at Manila International Airport which date back to its days under prior ownership when it was known as Asian Spirit. (The carrier adopted the Zest brand and the LCC model in 2008, abandoning the full-service regional model used when it was known as Asian Spirit.)

Zest's Manila slots have increased in value as the city's airport has become more congested; without them Zest would have struggled to secure a partner or buyer. Zest's owner had been looking for at least the last two years for new investors to support a capital infusion. A tie-up with AirAsia had been rumoured for several months before it finally came to fruition.

AirAsia is providing Zest with working capital, which should help the carrier stay afloat. But AirAsia has not disclosed how much it is investing into Zest and has not yet provided any details on the expected commercial partnership between the two carriers.

AirAsia would have likely been initially reluctant to partner with Zest as it generally prefers to grow organically, applying its own model from the ground up. A similar attempt in 2012 to accelerate growth in one of the AirAsia Group's other existing markets, Indonesia, ended with AirAsia walking away from the deal. Like Zest, Batavia was a struggling carrier but had a valuable portfolio of slots at Jakarta. Batavia, which also had a strong distribution network that would have improved AirAsia's access to the Indonesian domestic market, ceased operations in Jan-2013, just three months after AirAsia decided against proceeding with a deal to acquire the carrier.

See related articles:

• AirAsia faces uphill battle in Indonesian domestic market after dropping plans to acquire Batavia
• Mandala, Indonesia AirAsia and Citilink to benefit most from Batavia bankruptcy

The situation for AirAsia is different in the Philippines because AirAsia Philippines is much newer and has a much weaker position than Indonesia AirAsia. AirAsia Philippines just had its one-year anniversary and still only operates two aircraft, having repeatedly pushed back fleet expansion plans.

AirAsia Philippines needed a boost

AirAsia Philippines has struggled in its first year, suspending three of its initial routes - Clark International Airport to Puerto Princesa, Kota Kinabalu and Macau. The carrier, which is 40% owned by the Malaysia-based AirAsia Group, incurred a loss of MYR93 million (USD 30 million) in 2012, including MYR23 million (USD7 million) in 4Q2012. As CAPA reported on 5-Mar-2013:

AirAsia Philippines is now focusing more on the international market, with flights from its base at Manila alternative airport Clark, to Hong Kong, Kuala Lumpur, Singapore and Taipei. Its domestic network has been reduced to just 11 weekly flights and two destinations - Davao and Kalibo.

The AirAsia Group has said the Philippines affiliate will focus more on China markets and regional connectivity as it tries to improve profitability. The Clark-Taipei route, launched in Dec-2012, has been successful and has already been boosted from four to seven weekly flights.

But the carrier has already struggled in other markets in greater China, pulling off the Clark-Macau route. AirAsia Philippines is keen to open new routes to mainland China but this is unlikely to occur until tensions between China and the Philippines ease.

AirAsia Philippines' lack of slots at Manila, where its four LCC competitors all operate, puts the carrier at a competitive disadvantage. The AirAsia Group noted within its results announcement for 2012 that Clark's airport authority will commence shuttle bus services from Manila, improving connectivity from the city centre. But it is unclear if passengers will be swayed to take a bus through Manila's notoriously bad traffic when there are generally low fare flights available from Manila International.

See related article: AirAsia's 2013 outlook marred by intensifying competition and continued losses at affiliates

AirAsia's decision to forge a strategic partnership with Zest in a way is an admission that its original calculations showing it could successfully establish a Philippine carrier without a presence in Manila was flawed.

Clark is losing domestic capacity, although AirAsia Philippines has boosted international

In reality there is limited demand for services at Clark, particularly in the domestic market. AirPhil (which recently re-branded as PAL Express) in Feb-2013 dropped domestic services from Clark to Cebu and Puerto Princesa. Zest also dropped, at the end of Mar-2013, its only domestic route from Clark, a four times weekly flight to Kalibo which it had only launched in Dec-2012.

In principle, Clark is an attractive proposition in many ways - uncongested and reasonably accessible to the metropolis - but in the tightly contested and extremely price-sensitive Philippines market the slightest edge can be crucial. Currently there are less than 7,000 domestic weekly seats at Clark compared to over 17,000 domestic weekly seats just under one year ago, according to Innovata data. There are currently only 22 weekly domestic flights from Clark including a daily flight from AirAsia Philippines to Kalibo and four weekly flights from AirAsia Philippines to Davao; four weekly flights from SEAir to Kalibo; four weekly flights from PAL Express to Kalibo; and three weekly flights from Cebu Pacific to Cebu.

This figure will drop to only 18 at the beginning of May-2012, when the PAL Express flights, which are operated with Dash 8 turboprops, are to be discontinued.

Clark domestic capacity by carrier (one-way seats per week): 19-Sep-2011 to 22-Sep-2013

Source: CAPA - Centre for Aviation & Innovata

International services have generally been more successful at Clark, targeting price conscious passengers, particularly Filipinos who are working in other Asian countries. But fares and yields from Clark are generally significantly lower than the same routes from Manila.

Clark currently has over 37,000 international weekly seats, an increase of 77% over the same period last year. AirAsia Philippines has accounted for most of this increase as it quickly became the largest carrier at Clark.

AirAsia Philippines currently accounts for 37% of system-wide capacity and 33% of international seat capacity at Clark. When factoring in flights operated by AirAsia's Malaysian subsidiary, the AirAsia Group has a 39% share of international seat capacity at Clark.

Clark international capacity share (% of seats) by carrier: 1-Apr-2013 to 7-Apr-2013

Source: CAPA - Centre for Aviation & Innovata

Clark and AirAsia to benefit from opening up of Korean and Japanese markets

AirAsia will look to grow its leading market share further at Clark as its Philippine affiliate evaluates new international routes, including to China, South Korea and Japan. While China services are unlikely for the near term due to political tensions between China and the Philippines, the South Korean and Japanese markets will be opening up to new carriers, including AirAsia Philippines, as a result of the recent determination by ICAO that Philippine authorities are again in compliance with its safety standards.

In recent years South Korean authorities have blocked new Philippine carriers from launching services to the country while Japanese authorities have similarly blocked new Philippine carriers; Japan has also prevented carriers already serving Japan from adding capacity. South Korea and Japan are expected to soon remove these restrictions now that the Philippines have passed an ICAO audit.

Given the current slot restrictions at Manila, which tightened in mid 2012 after the domestic carriers agreed to cut peak hour movements by approximately 20% to reduce delays, new flights to both South Korea and Japan are likely from Clark.

Seoul is already served from Clark by Asiana and Korean Air LCC subsidiary Jin Air while Asiana also serves Clark from Busan. Zest launched a daily service on the Clark-Seoul route in late Oct-2012 but dropped the route in Mar-2013, leaving no Philippine carrier in the Clark-South Korea market. Neither are there currently any services between Clark and Japan.

Larger Manila will be the ultimate battleground

The Manila market, however, is much larger and more attractive. There are currently almost 450,000 domestic and almost 380,000 international weekly seats at Manila International Airport. While domestic seat capacity is down about 7% compared to year ago levels, this is driven by the reduction in peak hour movements that was implemented in mid 2012. Eventually airlines are expected to be able to reinstate their movements after capacity enhancements projects are completed, including realignment of Manila's secondary runway and moving general aviation traffic to another airport.

As movements are reinstated, preference will be given to the existing domestic carriers serving Manila that had reduced their movements. This includes Cebu Pacific, Philippine Airlines (PAL), PAL Express and Zest. Currently Zest is the fourth largest carrier at Manila with an 8% share of seat capacity.

Manila International system-wide capacity share (% of seats) by carrier: 1-Apr-2013 to 7-Apr-2013

Source: CAPA - Centre for Aviation & Innovata

The Zest partnership gives AirAsia access to the largest domestic markets in the Philippines. The carrier currently operates scheduled services on 12 domestic routes from Manila as well as on three international routes - Seoul, Shanghai and Quanzhou.

Zest Airways top 10 domestic routes based on capacity (seats): 1-Apr-2013 to 7-Apr-2013

Source: CAPA - Centre for Aviation & Innovata

Under the AirAsia tie-up, Zest is expected to drop its turboprop operation, which will free up further slots for more international services from Manila and/or the resumption of domestic flights to Bacolod and Cagayan de Oro, which were discontinued in Jun-2012. Turboprops do not fit in with AirAsia's point-to-point model although the largest LCC in the Philippines, Cebu Pacific, successfully uses ATR 72s to serve airports that cannot handle jets.

Four of Zest's Manila routes are currently served with its Xian MA60 turboprop fleet - Busuanga, Marindurque, Masbate and Tablas. These routes are not among the 20 largest domestic routes in the Philippines while Cagayan de Oro and Bacolod are the sixth and eighth largest domestic routes in the Philippines, making them obvious holes in the Zest and AirAsia networks.

Zest-AirAsia partnership could leave Tiger affiliate SEAir in vulnerable position

Partnering with Zest also gives AirAsia a response to rival LCC group Tiger, which entered the Manila domestic market in mid-2012 after acquiring a 33% stake in SEAir. The new Tiger affiliate has since been operating a fleet of five A320 family aircraft, with three aircraft serving domestic trunk routes from Manila and two aircraft serving primarily international routes from Clark.

AirAsia could look to duplicate this model, using its partner Zest primarily (and perhaps in future entirely) for the domestic market from Manila while focusing on international services from Clark. AirAsia Philippines will also likely follow Tiger's decision to focus SEAir entirely on A320 family aircraft, which could leave an opening for smaller Philippine regional carriers.

As in the case with Zest, SEAir previously operated turboprops on regional routes from Manila. SEAir last year reallocated the slots it had used for regional routes with turboprops to open up seven trunk routes which are now served with A319s/A320s. Zest will likely make a similar shift in 2013 at the suggestion of its new partner and part-owner AirAsia.

The new SEAir strategy however has not yet been successful and the carrier has been struggling. In 4Q2012, SEAir recorded a loss of SGD28 million (USD 34 million). Further fleet and network expansion has been delayed as SEAir tries to minimise losses. The Tiger Group has re-allocated to its Indonesian affiliate, Mandala, two A320 deliveries that were originally slated to go to SEAir in May-2013 and Jul-2013.

See related article: Tiger returns to profitability but still faces challenges in Australia, Indonesia and the Philippines

While SEAir has only operated A320 family aircraft since late 2010 (initially from Clark), Zest added its first two A320s back in 2008 after dropping the full-service regional carrier model and re-branding. Zest has since expanded rapidly, driven by the delivery of nine additional A320s. The carrier's domestic traffic increased nearly five fold, from only 374,000 in 2008 to almost 2.2 million in 2011 (see background information).

While its domestic traffic slipped slightly in 2012, Zest still captured 10% of the domestic market last year compared to only 1.5% for SEAir and 0.8% for AirAsia Philippines.

Philippine domestic market share (% of passengers carried): 2012

Source: Cebu Pacific using Philippine CAB data

The AirAsia-Zest partnership will put further pressure on SEAir as Zest, which Tiger reportedly also had the opportunity to acquire, becomes stronger. It is debatable if the Philippine market can support over the long term two major LCC brands alongside Cebu Pacific. AirAsia with Zest could give the duo an edge over Tiger/SEAir.

Consolidation is a welcome outcome in Philippine market

AirAsia Philippines, Zest and SEAir all struggled in 2012 as the Philippine domestic market was plagued by over-capacity and intense competition. The Philippine domestic market grew by nearly 10% to 20.6 million passengers but capacity was up by 16% to 28.3 million seats.

As a result the average seat load factor fell to about 73%, a very low figure for a price sensitive market that is primarily penetrated by low-cost carriers. (LCCs accounted for 80% of domestic passenger traffic in the Philippines during 2012, giving the Philippines the highest domestic penetration rate in the world.)

Zest saw its domestic seat load factor slip to 65.6% in 2012 as its passenger traffic dropped by 4%, despite an 8% increase in seat capacity. Smaller and newer AirAsia Philippines and SEAir suffered even more, recording domestic seat load factors of only 44.5% and 58.8% respectively. This highlights the challenges the carriers were faced with as they entered domestic trunk routes although the figures are not surprising given their very small market share and the unfavourable market conditions, which made it particularly tough for new entrants.

Philippine domestic seat load factors by carrier: 2012

Source: Cebu Pacific using Philippine CAB data

Philippine domestic passenger traffic and domestic seat capacity by carrier: 2012 vs 2011

Note: (1) fleet data is based on Cebu Pacific's own estimates
Source: Cebu Pacific using Philippine CAB data

The Philippine market was clearly in need of consolidation and rationalisation. The AirAsia-Zest tie-up is a step in the right direction, boosting the outlook for two carriers and the overall market. And Tiger's position in SEAir will also deliver some stability for that airline.

But more may be needed. The dynamic Philippine market could eventually see a full-fledged merger or a casualty.

Background information

Philippine annual domestic passenger traffic by carrier: 2004 to 2012

Note: *formerly known as Air Philippines; now known as PAL Express
**formerly known as Asian Spirit
Source: Philippines Civil Aeronautics Board

Philippine annual international passenger traffic by carrier: 2004 to 2012

Note: *later known as AirPhil Express; now known as PAL Express
**formerly known as Asian Spirit
Source: Philippines Civil Aeronautics Board

For the first article in this series see: Cebu Pacific sees bright outlook for 2013 as rationality returns to Philippines market